MERCATUS on POLICY Potential Restrictions on Title Lending
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No. 62 November 2009 MERCATUS ON POLICY POTENTIAL RESTRICTIONS ON TITLE LENDING By Todd Zywicki and Gabriel Okolski ne can hardly turn on a TV without seeing commercials in which cash-strapped indi- viduals bring their car titles to a lender for quick and easy loans. While auto title lend- ing may appear to be somewhat sketchy, it Ois actually a relatively safe and important source of credit for many Americans. However, current state legislation and a proposed federal rule seek to restrict this practice, with the very aim of protecting borrowers. This misguided paternalism will instead cut many people off from much- needed cash, encourage other, more dangerous lending practices, and potentially lead to other detrimental out- comes such as bounced checks or bankruptcy. Car Title LENDING AS A CreDit VeHicle Auto title lending grew out of traditional pawn shop operations, allowing borrowers to obtain larger loans by using one of their most valuable assets as collateral. The amount of a car title loan varies; though some studies have found that lenders typically lend about 33 percent of the resale value of the automobile,1 others have documented loans of 50 to 100 percent of the car’s value.2 Most loans range from $250 to $1,000, although some are larger.3 This compares very favor- ably to a typical pawnbroker loan, for which the average value is $70.4 And unlike pawnbroker loans, the borrower is able to keep the asset against which she is borrowing. Auto title loans also have highly transparent and easily under- stood pricing schemes. The only price point is the interest rate, and these loans generally do not involve up-front fees or prepayment charges. The Annual Percentage Rate (APR) on a title loan is typically 120–300 percent, depending on the amount borrowed.5 And while the borrower loses her vehicle in the case of default, the loan is usually non-recourse past that point, meaning that the borrower is not personally respon- sible for the debt. For example, if the car is not in operating MERCATUS CENTER AT GEORGE MASON UNIVERSITY condition because of a mechanical breakdown or is resold for In addition to consumers outside of the traditional lending less than expected, the lender is still limited to repossession channels, small, independent businesses rely on auto title and cannot sue the borrower for any deficiency. loans as an important source of short-term working capital. For example, a landscaping company may need several hun- dred dollars to purchase sod or bushes for a job or to meet WHO IS USING Title LENDING? payroll expenses. The proprietor may pledge his pickup truck Auto title loans fall under the category of non-traditional to obtain the necessary capital to buy the supplies to com- lending products, which appeal to individuals who may not be plete the job. Then when the job is complete, the businessman able to obtain more formal lending products or need to obtain receives payment and can redeem the collateral. emergency cash quickly. Perhaps contrary to popular intu- ition, some title lending is used by moderate-income earn- ers who have enough wealth to own a car of sufficiently high RISKS AND RewarDS value but who also have impaired credit. While borrowing against one’s car may seem to be an inherently dangerous practice, actual experiences with auto According to the American Association of Responsible Auto title lending have proven it to be a relatively reliable and sta- Lenders, the typical title loan customer for its members is 44 ble lending tool. Far from preying on low-income borrowers years old and has a household income of more than $50,000 who are unable to pay the loans back, title lenders seem to per year, but is excluded from traditional lenders such as be catering to a group of rational consumers who use this credit card companies, banks, credit unions, and small loan method as a means to obtain needed credit because theirs companies. In addition to these moderate-income borrow- has become impaired. ers, title loans also cater to lower-income consumers. A 1999 study analyzing data from the Illinois Title Loan Company For consumers who rely on these loans for essential needs, found that 37.6 percent of title loan customers earn less than the risks of outlawing title lending may outweigh the $30,000 per year, compared to 45.9 percent who earn more rewards. Although there is limited research on why con- than $40,000 per year. Additionally, approximately 46 per- sumers use title lending, research on other non-traditional cent of borrowers are repeat customers, and the average lending products (such as payday lending) is informative. loan duration is between three-and-a-half to four-and-a- A 2007 study found that 43 percent of payday loan custom- half months.6 ers had overdrawn their checking accounts at least once in the previous 12 months7 and primarily used funds for “bills, emergencies, food and groceries, and other debt service.”8 Research by two Federal Reserve economists found that Far from preying on low- when Georgia and North Carolina outlawed payday lend- ing, the incidences of bounced checks, consumer com- income borrowers who are plaints about debt collectors, and chapter 7 bankruptcy filings rose.9 Bounced checks and bankruptcy can be unable to pay the loans back, extremely detrimental to one’s credit and can carry higher title lenders seem to be costs than non-traditional lending products. Legislative bans on these lending options exchange a more-stable lend- catering to a group of rationa1 ing practice for practices that hurt low-income consumers. consumers who use this Industry sources report that about 14 to 17 percent of title method as a means to obtain loans default but that only about half of those (8 percent over- all) result in vehicle repossession.10 This high percentage of needed credit because theirs defaults that do not lead to repossession reflects the real- ity that many of the cars used as collateral tend to be older has become impaired. vehicles that often become damaged or break down over the course of the loan, limiting the incentives to expend the cost of repossession. Furthermore, according to the Ameri- can Association of Responsible Auto Lenders, more than 70 Title lending is especially attractive to customers without percent of its customers own two or more vehicles, making bank accounts and are a more attractive alternative than pawn repossession more of an inconvenience than a disaster. shop loans. Unlike pawn shop loans, title loans allow consum- ers to borrow larger sums of money, do not require borrowers As noted above, the alternative for many title loan borrowers to part with collateral, and do not require the transportation (specifically those who do not have bank accounts or credit of goods to the pawn shops. cards) is pawn shop loans. By way of comparison to title loan 2 MERCATUS ON POLICY NO. 62 NOVemBER 2009 default rates, one study found that 58 percent of all first-time FIGURE 1: NUMBER OF TITLE LENDERS IN FLORIDA BEFORE AND pawn shop loans default and only 37 percent are redeemed.11 AFTER THE IMPOSITION OF INTEREST RATE CEILINGS IN 2000 Another researcher found that default rates on all pawn shop 700 loans range from 13.9 percent to 30.2 percent.12 600 EFFectS OF LegiSlatioN Congress is considering two pieces of legislation that are 500 particularly threatening to non-traditional lending products like title pledge lending. The Protecting Consumers From Unreasonable Credit Rates Act of 2009, authored by Sen. 400 Richard Durbin (D-Il.), would place a flat interest cap of 36 percent on all consumer credit products. The House of Repre- 300 sentatives is also considering legislation to create a new Con- sumer Financial Protection Agency (CFPA) that would have Number of Auto Title Lenders Title Auto of Number unprecedented authority to determine the types of financial 200 products that consumers can choose. From a broad perspective, usury regulations that impose caps 100 on interest rates for certain types of loans tend to result in term re-pricing, product substitution, and credit rationing. 0 Under term re-pricing, lenders offset limits of what they can Pre Legislation Post Legislation charge on regulated terms by increasing the price of other Source: Policis, The Effect of Interest Rate Controls in Other Countries, August terms of the loan or related loan products. Since the terms of 2004, 17, http://www.microfinancegateway.org/gm/document-1.9.26998/25620_ a title loan are relatively transparent, this may be difficult. file_The_effect_of_interest_rate_controls.pdf. Instead, title loans may be more susceptible to product sub- friends and family, who may come from a similar demo- stitution, which arises when a particular consumer loan prod- graphic. The answer, therefore, for many may involve illegal uct cannot be priced to be made economically feasible. Each loan sharks and other dangerous avenues. This option is a very consumer ultimately desires to hold a certain amount of debt real consequence: A 2006 tightening of rate ceilings of con- based on income, saving preferences, and spending prefer- sumer loans in Japan has also been correlated with a dramatic ences. Restriction on auto title lending may force consum- growth in illegal loan sharking in that country, primarily run ers into a less-preferred mix of credit by eliminating some by organized crime.15 loans that title lenders were previously willing to offer. In some cases, this substitution may lead borrowers to riskier Furthermore, while policy makers may seek to limit auto title debt instruments. lending to reduce consumer over-indebtedness, the effects of term re-pricing and product substitution will simply shift con- Restrictive regulations could lead to a scenario of credit sumers to a different mix of terms (such as lower interest rates rationing, in which lenders limit their supply of loans because but higher up-front costs) or different, higher-cost products.